Investors are quite keen on making money quickly. One such method is to engage in a short sale. Though this strategy entails very high risk, we’ll look at how it works.
Sale without ownership
Selling a stock (or any other permitted financial asset) short means selling it without owning it. Though the concept may seem like an oxymoron, it is very real and a familiar idea for financial market participants. The primary reason behind this concept is the expectation that the price of the stock sold short will decline in the future, thus allowing the investor to buy the stock at a lower price and pocket the difference as profit.
How Does it Work?
An investor can sell a stock that he does not own by borrowing it from the broker or dealer through which the order is being executed. The understanding while conducting a short sale is that the investor will buy the stock back some time in the future. On their part, broker-dealers borrow the shares that are being short from custodian banks and fund management companies. The institutions lend shares in order to boost their revenue.
From an investor’s perspective, a short sale can be immensely beneficial as is illustrated below:
An investor short sells 100 shares of a company at £15 per share for a total of £1,500. If the price declines to £10, the investor can buy the same quantity of shares from the open market for £1,000 now and close his position, thereby pocketing £500 in the process. The actual profit will be a bit less because of the transaction costs and interest payments to the broker-dealer, but this is how short sales work.
A short sale is always done on margin, meaning that one can put in a trade with only part of the value of the total. In case of a successful trade, the gains are leveraged due to this reason.
In order to sell a stock short, an investor needs a margin account which is set up for him by the broker-dealer. Via this account, the investor is lent the cash to buy securities. Further, the broker-dealer also sets up purchase limits which restricts the value of trading that can take place on this account. A margin account is similar to a loan as periodic interest is payable to the broker for using the facility.
Since a short sale means selling an asset you don’t own, margin requirements are necessary as they act as a collateral and ensure that you will be able to buy back the sold shares (which you did not own). A margin account also allows the broker-dealer to sell your position on your behalf if it feels that you may not be able to buy the short sold stocks back.
Short selling is a risky strategy. Unlike a buy and hold investor, who has time to see his strategy work, a short seller needs to be able to time the market with a certain level of accuracy in order to make money.
But where short selling truly displays its risks are in terms of the potential loss to an investor. For a long-term investor, the worst that can happen is that a stock falls to zero. But even then his losses are limited to that amount. For an investor engaging in short selling, the losses are theoretically unlimited. This is so because the strategy bets on a stock declining. But if the price reverses course and starts rising, there is no ceiling beyond which it can’t rise. The more a stock rises, the more losses pile up on a short sale transaction.
One way to limit losses in a short sale is putting up stop loss orders which put price limits on the transaction and if the stock price rises beyond the pre-set level, the trade gets executed thus limiting the losses.
The crux of the short sale trade is that an investor should be aware that he is treading on extremely risky territory. While it can provide windfall rewards, it is fraught with risks, so professional guidance is necessary.